Japan to rein in regional banks' overexposure to bonds

TOKYO -- Japan's financial watchdog will introduce new regulations limiting regional banks' investment in domestic and foreign bonds, with the ultimate goal of steering the institutions away from excessive risk-taking and back to core lending operations.

Under the Financial Services Agency regulations, to be introduced in fiscal 2018, banks will be required to limit valuation losses on their bondholdings to 20% of core capital.

The regulations will target banks without overseas operational hubs. Among Japan's 106 top- and second-tier regional banks, some 95 will fall under this category. The country's 400 or more domestic credit unions and credit associations will be subject to the new rules, as will be some banks with broader bases including Aozora Bank, Shinsei Bank and Resona Bank, a unit of Resona Holdings.

Heading off losses

Under the Bank of Japan's negative interest rate policy, regional banks have been unable to generate profits from interest rate spreads in core lending operations, and have turned to investing in securities susceptible to interest rate fluctuations, such as foreign bonds. The FSA decided on the new regulations as the lenders could incur heavy losses when prices plunge.

At present, the FSA conducts a hearing if a bank incurs losses on bonds exceeding a fixed proportion of core capital. Under the new rules, potential losses would be calculated based on presumed price changes due to interest rate fluctuations. For example, banks would estimate their losses if rates shifted 1% on a yen basis, or 2% on a dollar basis.

If those calculations point to possible losses totaling over 20% of a bank's capital, the bank will receive a warning. The FSA could take additional action, such as requiring a report, if it deems necessary based on a hearing and the overall health of the bank's balance sheet.

Risky business

The FSA will impose similar rules based on the Basel III international banking guidelines on Japan's megabanks -- Mitsubishi UFJ Financial Group, Sumitomo Mitsui Financial Group and Mizuho Financial Group -- and other institutions starting this fiscal year. Given unstable market conditions, as seen in the spike in U.S. interest rates after the presidential election in November, it decided to apply the same regulations to domestic banks, albeit one year after imposing the rules on the megabanks. Under current market conditions, the agency believes around 30% of regional banks will run afoul of the new bond exposure rules.

At the end of April, top- and second-tier regional banks collectively held about 12.5 trillion yen ($114 billion at current rates) in U.S. Treasuries and other foreign bonds, showing an 80% increase over five years. Their holdings of Japanese government bonds, on the other hand, totaled about 29 trillion yen. That figure had dropped roughly 14 trillion yen since its peak in October 2012, shortly before the advent of Prime Minister Shinzo Abe's Abenomics policy. But compared to the megabanks, that pace of decline is moderate.

Facing investment difficulties, some regional banks have increased their holdings of extremely long-term bonds in search of relatively high yields. Limiting regional banks' JGB holdings could prompt a sell-off, but at present the BOJ's mass purchases of the securities are such that the effect on the bond market would be small.

Carrot and stick

In order to guide banks back toward core lending operations, the FSA is offering them certain freedoms even as it imposes new rules. Specifically, instead of rigorously assessing their loans, the FSA will give them more independence in assessing the financial health of borrowers.

The agency realizes that simply increasing lending will not lead to better earnings. But it is also dissatisfied with the way regional financial institutions operate, as it sees a number of businesses being denied loans. The FSA will encourage banks to look thoroughly into future business potential and lend proactively, even to borrowers that may be designated as bad debtors under present rules.

"We won't disallow banks from boosting profits through investment, but we also want them to think again what their core operations are," said one FSA official in April.